NN IP: Euro entry had a big effect on Italy's economy

Italy's entry into Europe's monetary union had a big impact on the country's economic performance. Reform has become the only option, and there is plenty of low-hanging fruit.

07.04.2017 | 07:34 Uhr

(Foto: Willem Verhagen, Senior Economist)

A few weeks ago, when we discussed French political risks, we made a very clear distinction between two issues. The first one concerns the acute political risks stemming from the possibility of a populist anti-EU party rising to power. The second risk is the slower-burning issue of a continued feedback loop between domestic and region-wide policy paralysis, high debt burdens, lowflation, sluggish growth momentum and increasing voter dissatisfaction. Myopic markets seem to focus mostly on the first but the second long-term issue could prove to be more important in the end. The main issue in Italy has been policy paralysis for a very long time already. This is probably also the main reason why Italy has a much lower "political dividend" than France. As discussed a few weeks ago, French spreads and the French banking system benefit enormously from the fact that France is a driving force behind European integration, together with Germany. Italy was also one of the founding countries but was never in the core group that drove the process of European monetary union.

In fact until the mid-1990s there was a very real risk that Italy would not be allowed in the monetary union, for reasons that applied equally well to Greece: Italy suffers from a long-standing situation of weak institutions and political paralysis. Historically high levels of inflation expectations as well as high budget deficits were a symptom of this situations. Over the past 20 years we have seen a detrimental feedback loop between these institutional and political drivers on the one hand, and sluggish (productivity) growth momentum on the other. It is interesting that weak institutions and frequent changes of government did not stop Italy from displaying healthy advances in real income per capita and total factor productivity (TFP) growth in the 1970s and 1980s. From a macro point of view, there are probably two reasons for this. First of all, the demand side was often supported by loose fiscal policy. In the 1970s Italian public debt as a percentage of GDP grew by 20pp on balance. It grew by a further 60 pp between the early 1980s and mid-1990s. This trend may very well have been partly the result of weak, internally divided governments that avoided hard political choices. Still, as a side effect, the impetus to demand created by this probably pushed business confidence, investment spending and the degree of churning in labour and product markets to a higher level (churning refers to the ease with which factors of production move around in the economy as well as the death rate of old firms and the birth rate of new firms). The second reason is probably the exchange rate. During the 1970s and 1980s Italy frequently devalued the lira, which allowed its businesses to continue to compete in European and global markets. We are not arguing that the exchange rate should be actively used to gain a competitive advantage, but rather that it can, in some cases, act as a passive safety valve that makes up for internal weaknesses such as higher inflation and institutional deficiencies.

In this respect it is indeed remarkable that Italian performance as measured by TFP growth and GDP per capita relative to its peers began to decline in the mid-1990s, which is precisely the time that Italy was getting ready to join the monetary union and aimed for exchange rate stability and fiscal austerity. To be sure, the latter was really necessary at the time. The economy had probably reached the point at which fiscal easing could no longer compensate for the lack of reform because the drawback in terms of high and rising sovereign risk premiums would then become too large. Nevertheless, the loss of the exchange rate safety valve has probably been a crucial determinant of Italy's bad economic performance over the past 20 years, given its inability and/ or unwillingness to reform. The level of Italian TFP declined by more than 5% since the late 1990s while it increased nearly 10% in France and more than 15% in the US over this period. Of course, the performance deteriorated the most after 2008 and in the banking system this caused a steady increase in the ratio of NPLs. This makes Italy very different from Spain and Ireland, which had an acute banking problem in 2008 because of a housing market collapse. This eventually resulted in an "acute" solution in the form of recapitalization as well. In the case of Italy this was a slow-burning issue caused not by excessive private debt but by a persistent lack of nominal growth. A fully satisfactory solution still has not been reached.

Reform is the only option and there is a lot of low hanging fruit

Of course the first-best solution to this problem is NOT exchange rate depreciation (assuming that were possible) but rather structural reform. Nevertheless, we do not live in a world of first-best solutions and politics is an essential reason why. Hence, back in the 1980s the second best solution of devaluation was not that bad after all. Still this route has been closed off firmly now. Even if Italy were to give up the euro its economy would be devastated by the consequences. Both the private and public sectors would face enormous uncertainty about the quality of their balance sheets, accelerating inflation expectations would impede a gain in competitiveness triggered by a depreciating new lira, and the sovereign would face prohibitive borrowing costs. Hence, the only option for Italy in the long run is to reform big time. In this respect, the demands of the core countries for deep structural reforms are fully justified, even though they forget these reforms will not work unless the demand side of the economy is supported as well.
The share of the population in Italy with tertiary education is well below the EU and OECD averages. This suggests that TFP growth could be rather easily stimulated by investing in education. However, it is also important to raise the return on education, which suggests a need to reform the labour market as well. In particular, "insiders" receive too much employment protection to the detriment of the "outsiders" (mainly younger workers). Renzi made some important progress in this respect last year by lowering the costs of firing and providing tax breaks for companies hiring permanent workers. Still, more needs to be done especially since these reforms do not touch existing employment contracts or public sector workers. In addition to this, product market regulation should be reformed as well to reduce excessive economic rents in certain professions and encourage more dynamism. All these reforms also require a substantial improvement in public administration and the justice system. Redundancy or bankruptcy procedures, for example, take a lot of time in Italy. Furthermore, Italy could reform its tax system so as to shift the tax burden from factors of production (mostly labour) to consumption.

In short, Italian structural reform is essential to push the economy out of its low growth, high public debt, high NPL ratio trap. For now the ECB's OMT and QE policies have done a lot to keep the 133% debt to GDP ratio sustainable. Still these policies are no panacea, at least not forever. At some point QE will end and German yields will hopefully normalize towards levels that are substantially higher than we observe today. Italy will probably always trade with a positive spread over Germany and this spread will in the long run no longer be protected by actual ECB bond buying. The only thing that will remain is OMT, but the ECB will only be able to activate this as long as the Italian government behaves like a good EMU citizen and complies with the rules on fiscal, banking and structural reform policy. If Italy were to get an anti-EU government or gets stuck in a situation of eternal policy paralysis, its OMT umbrella could thus prove to have a lot of big holes in it.Italy's political dilemma

In the end it thus all boils down to politics, and here the choice is really between two evils: in the short-term it is desirable to have an electoral system based on proportional representation (PR) because this minimizes the risk that an anti-EU government will come to power. However, in the long run it is highly desirable that Italy can choose governments that have the ability to push through reforms. This may be next to impossible under PR, given the high degree of political fragmentation. Because of these issues, the exact shape and form of the electoral system remains very important. The Constitutional Court ruling of January 25 ruled that the second round of the current electoral law for the Lower House (Italicum) is unconstitutional. This second round would be triggered if no party gets more than 40% of the vote in the first round and envisages a competition between the two parties with the highest share of the vote. The winner of the second round would then get a plurality premium (54% of the seats). However, the Court maintained the plurality premium in the first round, i.e., if a party gets more than 40% of the vote it gets 54% of the seats. If no party gets more than 40% the seats are assigned according to the PR system. Meanwhile, the electoral law for the Senate (which is as powerful as the Lower House) is still based on PR. This would be the system under which elections would operate if they were held today. Because no party is polling anywhere near 40%, the result of such an election would thus probably a political stalemate. In this respect, one must bear in mind that according to the polls, the share of the vote for Eurosceptic parties (5SM, Northern League and Brothers of Italy) is around 45% which would make the formation of a stable government extremely difficult.

Still, it is far from certain that elections will take place under this system. The intention of many parties still seems to be to change the electoral law even though this issue is intertwined with their preference for the election date. 5SM and Northern League seem to want elections as soon as possible, while Renzi's PD party first wants to change the electoral law. The slight complication for Renzi is that a small fraction of his party has split off and is now continuing under the name of the Democrats & Progressives (DP). The DP party is unlikely to cause a government downfall because it is in their interest to postpone the date of election. This is was the preference of most defectors in the first place and being a new kid on the crowded Italian political block there is a premium on postponing the election date because this may afford valuable time to try an increase your share of the vote at the expense of the "mother party". Meanwhile, Renzi's party seems to have a preference for returning to the Materellum which was the electoral law before 2005 where 75% of MP's were elected via the "first past the post system" (like they have in the UK) and 25% through PR. What's more, the PD wants to extend this system to the electoral law for the Senate. Finally, Berlusconi's Forza Italia wants a fully PR system without a majority premium.

The outcome of all this is still highly uncertain but at this stage contains the following elements:

Harmonizing the electoral system for the Lower House and the Senate seems to be regarded as highly desirable given that both Chambers have equal powers.

The President of the Republic plays a crucial role in deciding when Parliament will be dissolved. He seems to prefer a voting system that yields governable majorities in both houses. This could mean that the majority premium is extended to coalitions (and applied in both houses) or removed completely.

The Materellum could be a viable alternative to the current law (Italicum) since it may produce relatively homogeneous coalitions without the explicit majority premium embedded in the latter. The Materellum was operative between 1993 and 2005 and did not prevent small parties from entering Parliament. Still, it was also more conducive to parties more or less coalescing around a right-wing and left-wing pole which yielded less political fragmentation than under the purely proportional system in place before 1993.

The date of the next election has become highly uncertain. The PD congress will take place in late April and before this time, changes to the electoral law are pretty unlikely. This does not rule out an election in June but time would be pretty short. An election in the autumn is then a possibility but this could clash with the requirement that Italy submits its fiscal plans for 2018 to Brussels around that time. As a result, postponement to Q1'18 is now again our base case.

Given the high combined support for anti-EU parties, a "one-purpose" coalition between the anti-EU parties with the aim of trying to organize a referendum is a tail risk. Still, one has to bear in mind that on other policy issues there are very large differences between 5SM and Northern League. A voting system which gives an incentive to parties to form a coalition before the election to capture the plurality premium would reduce this tail risk.

The split in Renzi's PD party could well cause a permanent increase in the degree of political fragmentation. How serious this will turn out to be will depend on the new electoral system and on whether the DP party will be willing to form a coalition with the PD party.